Efficiency and Market Imperfection Notes, page 1, 2001; Bruce Brown I. Important Expressions Regarding Tax. raise revenue = government collect tax money from taxpayers levies a tax = government starts to collect tax (passes a law requiring payment of tax, or institutes a tax) bears the burden = to “really” pay the tax, to by hurt by the tax (compare post-tax price paid by buyer or received by seller with what they would have paid or received without a tax) impact of the = the effect of the tax (on price paid by buyers, received by sellers; and quantity bought and sold or “transacted”) a tax wedge = separates the price buyers pay from the price sellers receive (after tax) II. Crucial Points Regarding a Per-Unit Tax Consider a tax charged “per-unit” in a specific market; e.g., “10 cents per avocado” 1) an excise tax legally “on” sellers will shift upward the supply curve 2) a sales tax legally “on” buyers will shift down the demand curve 3) to see who “really” pays the tax, (i.e., to determine the economic incidence of the tax), one should compare the prices after the tax is imposed, to those which would exist without the tax. 4) Economic incidence does not depend on legal incidence. That is, in theory the effect charging buyers 10 cents per avocado bought (shown by parallel downward shift in demand) is exactly the same as charging sellers 10 cents per avocado sold (shown by parallel upward shift in supply). The only difference is whether the posted price (on the sign or on the price tag) includes the tax or not. For example, the previous two situations are economically identical. The only difference is whether the “sticker price” includes the tax (e.g., as with gasoline tax) or not (e.g., as with the ordinary sales tax). Suppose the price of an avocado is $1, and that a 10-cent-per-avocado sales tax exists. In this example the tax is legally “on” the buyers. The sticker price reflects what the seller actually receives ($1.00 per avocado), and the actual price buyers pay, after tax, is $1.10 per avocado. A 10 cent wedge exists between the price the buyer pays and that which the seller receives. Realize, that in order to find the economic incidence of the tax (find who “really” pays the tax) we must consider what the price would be if there were no tax. Theory suggests that in a world without a tax, the market equilibrium price of avocados would have been between $1.10 and $1.00 per avocado. Suppose it would have been $1.07. Realize without a tax, the posted price would reflect both the amount paid by buyers, and received by sellers. Then the economic incidence of the 10 per avocado tax is: 3 cents per avocado on the buyers (110-107), and 7 cents per avocado on the sellers (107-100). In this example we can visualize the tax as shifting down demand by 10 cents. If the tax were officially collected from the sellers (an “excise tax,” where the sticker price includes the tax) this could be visualized by shifting up the supply curve by 10 cents. Perhaps the most straightforward general way to depict that effect of a tax on a good is to simply use the original pre-tax supply and demand curves and show the tax as driving a wedge between the height of the demand and supply curves (prices which buyers pay and sellers receive). III. In theory, a free market with no government implies ALLOCATIVE EFFICIENCY (Allocative Efficiency means the efficient quantity of the good is produced) Assume: a) buyers and sellers have full (perfect) information b) there are many buyers and sellers who behave competitively c) there are no external benefits or costs d) the good is a “pure private good” that is has no characteristics of a “public good” e) property rights are clearly defined and enforcedEfficiency and Market Imperfection Notes, page 2, 2001; Bruce Brown Then: -- Height of demand curve = marginal social benefit (MSB) = marginal private benefit (MPB) to the consumer consuming the good. -- Height of supply curve = marginal social cost (MSC) = marginal private cost (MPC) to the firm producing the good. Allocative Efficiency in a market can be seen one of two ways: 1) the MSB = MSC for the last unit produced (for all units produced MSB is greater than or equal to MSC) -or- 2) the sum, consumer surplus plus producer surplus, is maximized If for some reason, Q* is not transacted (bought and sold) in this market, inefficiency is implied. Government may be able to increase efficiency by causing a quantity closer to Q* to be transacted. IV. Five Efficiency-based Reasons for Government Intervention in Markets: 1. Imperfect Competition, “Monopoly Power” If there are a small number of producers, they may collude to restrict the quantity sold in the market (below Q*) so as to raise the price charged customers. This may increase Producer Surplus, but reduce Consumer Surplus by a greater amount. That is, the monetary value of the gain to producers will be smaller than the monetary loss to consumers, thus implying inefficiency. Government may use anti-trust policy to prevent this reduction in the quantity sold in the market (e.g., make it illegal for firms to collude to restrict quantity). Real world application of antitrust policy may be more complicated. In a very important current case, U.S. federal (and some state) governments have filed law suits against Microsoft, the maker of MS Windows, MS Word, MS Excel, etc. Microsoft is accused of activities that will make it more difficult for other computer firms to sell their computer software. The basic idea is that with reduced competition, Microsoft will be able to charge a higher price in the future (a complication is that Microsoft may force other computer software companies out of the market by giving away their software for free now; AND if consumers may get free software now, they may benefit now; BUT with fewer competitors in the future Microsoft will be able to raise prices and hurt consumers in the future -- our model has no time, and so has difficulty describing this) Supply Curve’s Height = Marginal Social Cost MSC, which also equals Marginal Private Cost MPC experienced by the firm Demand Curve’s Height = Marginal Social Benefit MSB, which also equals Marginal Private Benefit MPB experienced by the consumer Quantity Price Q*efficientEfficiency and Market Imperfection Notes, page 3, 2001; Bruce Brown 2.